Wednesday, April 23, 2008

Boulder representative Claire Levy, a Democrat, wants to stop Wal-Mart and other companies from deducting real-estate expenses they're paying to themselves. The Wall Street Journal explained how this works:

The arrangement takes advantage of a tax loophole that the federal government plugged decades ago, but which many states have been slower to catch. Here's how it works: One Wal-Mart subsidiary pays the rent to a real-estate investment trust, or REIT, which is entitled to a tax break if it pays its profits out in dividends. The REIT is 99%-owned by another Wal-Mart subsidiary, which receives the REIT's dividends tax-free. And Wal-Mart gets to deduct the rent from state taxes as a business expense, even though the money has stayed within the company.

All legalities aside, I see the root of the problem in the difference in the costing for GAAP accounting and tax purposes and costing for economic decision making. One key economic cost component, Opportunity Cost, does not figure in the GAAP and Tax accounting. Looking at Wal-Mart's plan to pay rent to itself and claim state tax deduction, this seems acceptable from an economic perspective.

It does not matter whether they own the property or not, they have to account for the opportunity cost of investing the capital in the real estate and using that property for its retail purposes vs. other opportunities for the capital or for the property like renting it out to others.

An alternative to the current tax bill by Rep. Levy is to consider a "Carbon Tax". Instead of levying state tax on the corporation's income, the state should tax the former's operations that impact the land and environment. This is equivalent to state recouping the Opportunity cost of the land and the environment being used by a store as opposed to the next best alternative.